The political risks of the Senkaku/Diaoyu island dispute are heavily mispriced in global markets. Conflict is still on the table.

For more than a year now Japan and China have quarreled over the Senkaku/Diaoyu islands, and the tension sharpened significantly following China’s move to create a new “air defence identification zone” over the islands in November – a move which Japanese Prime Minister Shinzo Abe called “dangerous.” This long-running conflict rattles the market every now and again, so far without erupting into actual war.

Neither side has any interest in letting the dispute escalate at present. Indeed, the reaction from the market was much bigger in 2012, when the Japanese elections and the change in China’s leadership added to the uncertainty. However, some military analysts and regional experts regard the potential clash over the Senkaku/Diaoyu islands as the most underpriced of foreseeable geopolitical risks. If it escalates, it could drag the three largest economies in the world – China, Japan and the US – into conflict.

In mid-November, when China created the “air defence identification zone” over the islands, markets barely shrugged at the news. After a prolonged period of low interest rates has driven investors into riskier assets, pricing distortions caused by multilateral and continued quantitative easing have led to a mispricing of political threats, leaving them unaccounted for and potentially destabilizing, if they were to occur. The island dispute is one of those threats.

The VIX Index, which is a measure of market expectation of 30-day volatility, often dubbed the “investor fear gauge,” shows that the most volatile trading days in US stock markets are caused by political events rather than central bank policy statements or data releases. In a report published in November by Citigroup, the high impact of global events suggests that “political risks could emerge as a bigger theme in 2014,” underscoring “how interlinkages remain strong, despite the post-Lehman Brothers fragmentation of markets.”

At the annual World Economic Forum (WEF) held in Davos, Switzerland in late January, one of the headline-grabbing topics was the political tension building between China and Japan. While the islands are essentially useless to either nation, national pride and historic hatreds have escalated the conflict. Shinzo Abe’s recent visit to the Yasukuni Shrine in Tokyo was perceived as an act of honouring war criminals, according to a Chinese professional attending the WEF.

Beijing knows that the US would have to take a stand, siding with its strategic ally Japan, if the Chinese assert control over the islands. However, China-US ties certainly matter. The economic relationship between the two largest economies in the world means that the issue will be downplayed by the US a long way down the road to avoid fully fledged conflict.

The Chinese change in leadership since 2012 influences the political risk of conflict. According to Ian Bremmer, Xi Jinping possesses control over the military in a way Hu Jintao never did. Xi would have a much easier time rallying support for military action, and anti-Japanese nationalism now might allow China to defuse some of what would otherwise be discontent with things of a more problematic nature. Japan is a thorn in China’s side, given the opacity of Japanese society, which allows no significant Chinese business influence. Most immediate and not-so-immediate neighbours are locked in a tight, economic embrace with China, securing a certain level of mutual interests and co-dependence. Not so with China and Japan.

Word from Davos is that China believes a “surgical, targeted invasion” could succeed in signaling Chinese dominance without provoking an actual conflict. Even a “surgical invasion” of minor scale would appear an unnecessary, aggressive, and potentially dangerous move, but as Gideon Rachman of the FT tweeted from Davos: “Just interviewed Shinzo Abe @Davos. He said China and Japan now are in a “similar situation” to UK and Germany before 1914.”

The likelihood of China engaging militarily with the United States in the region is very low, but the attitudes and suggestions seeping out from WEF raise concerns that alternative types of warfare – economic conflict, cyber-attacks and perhaps even a “surgical, flag-carrying invasion”– are being considered.

Elaboration from a friend of mine, Guy Wallace, who has observed and delved into this in detail, working in Japan:

“The large oil and gas reserves, the full extent of which are not yet known, are a significant factor for both countries. EIA thinks there could be around 100 million barrels of oil and 2 trillion cubic feet (TCF) of natural gas in the East China Sea, Chinese sources guess around 160 billion barrels and 250 TCF of natural gas, more oil than the whole of Iran.

Japan is finally escaping deflation but the weaker yen is hitting energy imports hard, especially in a no-nuclear post-Fukushima Japan, giving the wrong kind of inflation that won’t push up wages. Any potential source of energy reserves of oil are far from useless. That’s not to mention the fishing potential and key shipping lanes of the area (tuna is getting rare here, I went to an auction where one sold for £0.5m!).

Termed China’s “cabbage strategy”, the long game of incremental steps has worked in other areas such as against Vietnam in the parcel islands in the South China Sea, but it is unlikely to work here anytime soon due to the US treaty presence. In the long term however, 50+ years, the US will slowly have it’s military resources drained, at which point China can point back to measures such as the ADIZ etc as reference to legitimacy. Like you, I don’t see any large scale conflict anytime soon as all sides have too much to lose, both sides will continue in stalemate even if there is an unforeseen accident, economic risk of a slowdown in trade if tensions rise is potential but not enough to significantly alter current pricing in by investors, same goes for cyber attacks which would only damage China’s overseas reputation.”